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Regulation, Credit Risk Transfer with CDS, and Bank Lending


  • Thilo Pausch

    () (Deutsche Bundesbank, Central Office, Department of Banking and Financial Supervision, Wilhelm-Epstein-Straße 14, 60431 Frankfurt am Main)

  • Peter Welzel

    () (Universität Augsburg, Wirtschaftswissenschaftliche Fakultät, Lehrstuhl für Volkswirtschaftslehre, Ökonomie der Informationsgesellschaft, Universitätsstraße 2, 86135 Augsburg)


We integrate Basel II (and III) regulations into the industrial organization approach to banking and analyze the interaction between capital adequacy regulation and credit risk transfer with credit default swaps (CDS) including its effect on lending behavior and risk sensitivity of a risk-neutral bank. CDS contracts may be used to hedge a bank’s credit risk exposure at a certain (potentially distorted) price. Regulation is found to induce the risk-neutral bank to behave in a more risk-sensitive way: Compared to a situation without regulation the optimal volume of loans decreases more as the riskiness of loans increases. CDS trading is found to interact with the former effect when regulation accepts CDS as an instrument to mitigate credit risk. Under the substitution approach in Basel II (and III) a risk-neutral bank will over-, fully or under-hedge its total exposure to credit risk conditional on the CDS price being downward biased, unbiased or upward biased. However, the substitution approach weakens the tendency to over-hedge or under-hedge when CDS markets are biased. This promotes the intention of the Basel II (and III) regulations to “strengthen the soundness and stability of banks”.

Suggested Citation

  • Thilo Pausch & Peter Welzel, 2013. "Regulation, Credit Risk Transfer with CDS, and Bank Lending," Credit and Capital Markets, Credit and Capital Markets, vol. 46(4), pages 439-465.
  • Handle: RePEc:kuk:journl:v:46:y:2013:i:4:p:439-465

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    References listed on IDEAS

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    Cited by:

    1. Chen, Shi & Chang, Chuen-Ping, 2015. "Should bank loan portfolio be diversified under government capital injection and deposit insurance fund protection?," International Review of Economics & Finance, Elsevier, vol. 38(C), pages 131-141.
    2. Kero, Afroditi, 2013. "Banks’ risk taking, financial innovation and macroeconomic risk," The Quarterly Review of Economics and Finance, Elsevier, vol. 53(2), pages 112-124.
    3. Chang, Chuen-Ping & Chen, Shi, 2016. "Government capital injection, credit risk transfer, and bank performance during a financial crisis," Economic Modelling, Elsevier, vol. 53(C), pages 477-486.
    4. Saibal Ghosh, 2015. "Macroprudential regulation and bank behaviour: theory and evidence from a quasi-natural experiment," Macroeconomics and Finance in Emerging Market Economies, Taylor & Francis Journals, vol. 8(1-2), pages 138-159, July.
    5. Broll, Udo & Welzel, Peter & Wong, Kit Pong, 2016. "The banking firm under ambiguity aversion," CEPIE Working Papers 01/16, Technische Universität Dresden, Center of Public and International Economics (CEPIE).
    6. Broll, Udo & Guo, Xu & Welzel, Peter & Wong, Wing-Keung, 2015. "The banking firm and risk taking in a two-moment decision model," Economic Modelling, Elsevier, vol. 50(C), pages 275-280.
    7. Arnold, Marc, 2013. "This article analyzes the impact of the introduction of centrally cleared credit risk transfer on a loan originating bank's lending discipline in the primary loan market. Under Basel III, a bank can t," Working Papers on Finance 1321, University of St. Gallen, School of Finance, revised Dec 2014.
    8. Kick, Thomas & Pausch, Thilo & Ruprecht, Benedikt, 2015. "The winner's curse: Evidence on the danger of aggressive credit growth in banking," Discussion Papers 32/2015, Deutsche Bundesbank.
    9. Shi Chen & Ku-Jun Lin, 2015. "Credit Risk Hedging, Deposit Insurance Fund Protection, and Default Risk in Retail Banking during a Financial Crisis," Research in World Economy, Research in World Economy, Sciedu Press, vol. 6(1), pages 118-132, March.
    10. Tsai, Jeng-Yan, 2013. "Bank interest margin management based on a path-dependent Cobb–Douglas utility framework," Economic Modelling, Elsevier, vol. 35(C), pages 751-762.

    More about this item


    Banking; Regulation; Credit Risk;

    JEL classification:

    • G21 - Financial Economics - - Financial Institutions and Services - - - Banks; Other Depository Institutions; Micro Finance Institutions; Mortgages
    • G28 - Financial Economics - - Financial Institutions and Services - - - Government Policy and Regulation


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